Long-term debt to equity ratio

The long-term debt to equity ratio is a method used to determine the leverage that a business has taken on. To derive the ratio, divide the long-term debt of an entity by the aggregate amount of its common stock and preferred stock. The formula is:

Long-term debt ÷ (Common stock + Preferred stock)

When the ratio is comparatively high, it implies that a business is at greater risk of bankruptcy, since it may not be able to pay for the interest expense on the debt if its cash flows decline. This is more of a problem in periods when interest rates are increasing, or when the cash flows of a business are subject to a large amount of variation, or when an entity has relatively minimal cash reserves available to pay down its debt obligations.

The ratio is sometimes used to compare the leverage level of a business with those of its competitors, to see if the leverage level is reasonable.

The standard debt-to-equity ratio can be a more reliable indicator of the financial viability of a business, since it includes all short-term debt as well. This is especially the case when an organization has a large amount of debt coming due within the next year, which would not appear in the long-term debt to equity ratio.

Related Courses

Business Ratios Guidebook 
The Interpretation of Financial Statements